Abstract:
This paper studies the time-consistent taxation of personal income in a stochastic small open economy. The benevolent government of the small open economy chooses taxes on labor and home asset income to finance a stochastic stream of government expenditure. Taxation of foreign asset income is not enforceable, as personal savings can be hidden in an international capital market with a bank secrecy. The focus is on government policies that are time-consistent and balance the government's budget. After parameterizing the benchmark economy, the economic effects of introducing an international tax agreement that allows for the taxation of foreign asset income are analyzed. The paper finds that the time-consistent taxation of foreign asset income leads to welfare losses between 1 and 2 percent of annual consumption as the incentives for asset accumulation are substantially diluted. The stationary average foreign asset income tax is around 45 percent and the labor income tax decreases from 30 percent to 25 percent compared to the benchmark economy where asset income taxes can be avoided. The Ramsey policy on the other hand suggests a stationary average foreign asset income tax close to zero and a labor income tax of 29 percent, and yielding slight welfare gains compared to the benchmark economy. The results of the paper challenge the introduction of international tax instruments on personal asset income XX (Fatca in the U.S., Automatic Exchange of Tax Information among OECD countries) as well as the bilateral withholding tax agreements that Austria and the United Kingdom signed with Switzerland during the recent European debt crisis.
